To beat the stock market, buy quality

Quality stocks are expensive, but offer high returns and low risk

You can beat the market over time through “smart timing” and by investing in value stocks. And there is another way that may be even easier.

Indeed it is so easy it seems too good to be true.

Wall Street not so sure about mom-and-pop

(3:54)

Mom-and-pop investors are returning to stocks, but their renewed optimism is considered by many professionals to be a warning sign. Alexandra Scaggs reports on MoneyBeat. Photo: Getty Images.

New research has found that you could have beaten the market over many years simply by investing in the highest-quality, strongest, safest companies.

Not only did they produce higher returns and lower risk, they actually did best in times of market turmoil. In other words, they offered you something close to a free insurance policy against meltdowns like 2008.

“Quality,” observed Jeremy Grantham, legendary co-founder of Boston fund firm GMO, “has outperformed forever.” GMO’s own data, tracking “high quality” companies, finds that they have outperformed the Standard & Poor’s 500-stock index by a cumulative 50% since 1965. Furthermore, he says, Standard & Poor’s itself has tracked its own index of quality companies, the “High Grade Index,” since 1925 and it has “handsomely outperformed” the rest of the market over the entire time—especially during periods such as the Great Depression.

High-quality stocks have produced superior returns with far lower risk, Grantham notes. They are, in other words, a “free lunch” for investors. (Grantham, “Playing With Fire,” April 2010, at www.gmo.com. Registration required.)

Gunnar Pippel / Shutterstock.com

“Quality” isn't the same as “value.” Quality stocks are often more expensive in relation to their net assets or earnings than other stocks. “Quality” usually refers to companies that are highly profitable, which have strong balance sheets, stable earnings, respectable growth, and good cash flow. They have excellent credit ratings. They typically have very strong brands or patents or other “defensive moats” that allow them to fend off competitors without slashing prices. GMO’s list of “high quality” U.S. companies include the blue-chip names you’d expect—such as old dependables like Chevron
CVX, -4.89%
, Wal-Mart
WMT, -0.25%
, Johnson & Johnson
JNJ, +0.37%
, McDonald’s
MCD, +0.70%
, and Procter & Gamble
PG, -0.89%
, along with newer tech names like Apple
AAPL, -0.87%
, Google
GOOG, -1.10%
and Microsoft
MSFT, -0.38%
.

Over time, a portfolio of high-quality names has beaten the market—even though the stocks have typically been more expensive than the overall market—and offered lower risk.

This finding was supported by research published recently by Cliff Asness and Andrea Frazzini at AQR Capital and Lasse Pederson of New York University. They looked at the performance of nearly 40,000 stocks in 24 countries, including the U.S., since 1951. They sorted out the “quality” companies using four measures—high profitability (measured by returns on assets), high earnings growth (measured by growth over the previous five years), safety (measured in terms of low stock volatility, low leverage, stable earnings, and high credit ratings), and payouts (measured as the percentage of earnings paid to investors as dividends or through share buybacks).

Their conclusions were threefold. The first was that high-quality stocks tended to trade at higher prices, in relation to assets and earnings, than lower-quality ones. In other words, the market had correctly identified higher-quality companies, and paid a premium for them. However, their second point was that the market didn’t pay enough of a premium for these companies. Even though they were more expensive, their stocks still outperformed the market over time because they did even better than the optimistic market had expected. And, thirdly, they found that quality persisted—that high-quality companies tended, in the main, to stay high quality.

Over time, says NYU’s Pederson, “quality” tended to beat the overall market by about three percentage points a year, with substantially lower volatility. That is a huge gain over time.

What this means is that you could have beaten the market simply by putting together a broad portfolio of top-quality companies and then pretty much leaving them alone, with minimal interference. Furthermore, such stocks tended to do best at times of stress—so not only did you not have to worry about them, you could probably have owned more of them, and fewer bonds, because they would have fallen by much less in times of crisis.

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